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Monday, May 4, 2015

Venture Capital Prices: Real or Make Believe?

Market efficiency and discounted cash flow analysis are
important M&A concepts and tools. Their usefulness is questionable in the
sometimes surreal realm of venture capital. Current venture capital valuation
based on financing rounds keeps rising with the number of unicorns (private
early stage firms with implied $1B+ values) at record levels. Reverse
engineering the operating performance needed to justify such lofty values leads
to some hard to believe let alone justify sales and margin estimates.

A possible explanation
is the prices reflect the value of special downside protection features like
liquidation preferences available to venture fund investors. The extra value
for those features does not seem large enough to explain the huge current price
run up.

This leads to another
explanation; namely, the prices and implied values are an illusion. Unlike
public shares you cannot short
sell private investments if you believe they are overvalued. Absent short
sales or some other mechanism prices take on a life of their own. All that is
needed for a self fulfilling momentum based pricing cascade are
optimistic investors and liquidity. The uptick in prices draws additional
investors and the beat goes on. Disbelieving investors are unable to bet
against the “excessive” prices. Thus, an apparent arbitrage opportunity goes
unanswered.

It appears venture capital markets are inefficient-their
prices do not reflect available information and views. Instead, they resemble
lotteries-relatively low ticket prices for negative expected value investments
with a large positively skewed payoff distribution. Venture funds and other
investors are pressured to participate even at higher prices. They fear missing
out in getting a winning ticket, and suffering a relative performance drop,
which impacts their fund raising efforts. These types of one way markets can
remain inefficient for long periods until some event occurs causing a
revaluation. Optimistic momentum venture investors with sufficient liquidity
will keep bidding up implied finding round valuations.

Interesting to see what values, if any, are realized once
surviving start-ups are taken public and begin trading in a market where short
sales are possible. I predict IPO investors will be in for a wild ride.
Optimists will keep setting venture values until we run out of optimists.
Sounds like a game of musical chairs-you do not want to be the last one
standing when the music stops.

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About MergerProf

In addition to their day jobs, Joe and Ralph teach acquisition finance at the Amsterdam Institute of Finance. This blog was created in the summer of 2012 as a tool for those interested in acquisition finance and related material. Admittedly, we define related material broadly to include mergers, private equity, banking, governance, deal making and, well, finance in general. We hope you will enjoy and contribute, critiquing, expanding and providing your own examples related to the posts. We encourage you to join us in this adventure and, for some of you, to see you in Amsterdam, New York or Philadelphia.